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CHAPTER 5 TIME VALUE OF MONEY Chapter Outline - Cost-Benefit Analysis - Market Prices and the Valuation Principle - The Time Value of Money and Interest Rates - Valuing Cash Flows at Different Points in Time Learning Objectives Identify the role of financial managers and competitive market...
CHAPTER 5 TIME VALUE OF MONEY Chapter Outline - Cost-Benefit Analysis - Market Prices and the Valuation Principle - The Time Value of Money and Interest Rates - Valuing Cash Flows at Different Points in Time Learning Objectives Identify the role of financial managers and competitive markets in decision making Understand the Valuation Principle, and how it can be used to identify decisions that increase the value of the firm Assess the effect of interest rates on today’s value of future cash flows Calculate the value of distant cash flows in the present and of current cash flows in the future 1- Cost-Benefit Analysis Role of the Financial Manager Make decisions on behalf of the firm’s investors ◼ For good decisions, the benefits exceed the costs 1- Cost-Benefit Analysis Role of the Financial Manager Real-world opportunities are often difficult to quantify and involve using skills from other management disciplines: ◼ Marketing ◼ Economics ◼ Organizational Behavior ◼ Strategy ◼ Operations 1- Cost-Benefit Analysis Quantifying Costs and Benefits Any decision in which the value of the benefits exceeds the costs will increase the value of the firm 1- Cost-Benefit Analysis Quantifying Costs and Benefits Role of Competitive Markets ◼A competitive market is one in which a good can be bought and sold at the same price ◼ In a competitive market, the price determines the value of the good ◼ Personal opinion of the “fair” price is irrelevant Evaluate: As we emphasized earlier, whether this opportunity is attractive depends on its net value using market prices. 2- Market Prices and the Valuation Principle The Valuation Principle The value of a commodity or an asset to the firm or its investors is determined by its competitive market price The benefits and costs of a decision should be evaluated using those market prices When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm Evaluate: Since we are transacting today, only the current prices in a competitive market matter Our own use for or opinion about the future prospects of oil or copper do not alter the value of the decision today Since we are transacting today, only the current prices in a competitive market matter 2- Market Prices and the Valuation Principle Why There Can Be Only One Competitive Price for a Good Law of One Price ◼ Incompetitive markets, securities with the same cash flows must have the same price 2- Market Prices and the Valuation Principle Why There Can Be Only One Competitive Price for a Good Arbitrage ◼ Themethod on the stock exchange of buying something in one place and selling it in another place at the same time, in order to make a profit from the difference in price in the two places Arbitrage Opportunity ◼ Any situation in which it is possible to make a profit without taking any risk or making any investment 3- The Time Value of Money and Interest Rates The Time Value of Money In general, a dollar today is worth more than a dollar in one year ◼ If you have $1 today and you can deposit it in a bank at 10%, you will have $1.10 at the end of one year The time value of money is the difference in value between money today and money in the future. 3- The Time Value of Money and Interest Rates The Interest Rate: Converting Cash Across Time By depositing money, we convert money today into money in the future By borrowing money, we exchange money today for money in the future
